My Plan to Save the Universe
About a year ago, Treasury Secretary Geitner had the nerve to come out and say that he wants to set up a fund that would "encourage" private entities (hedge funds) to buy some of the toxic assets we hear so much about that are infecting banks' balance sheets. Most of these toxic assets are junk bonds backed by mortgages, pieces of mortgages, and insurance on the junk bonds which are backed by pieces of mortgages, and even insurance on the insurance on the bonds that are backed by pieces of the pieces of the worst tranches of sub prime mortgages. There are even more complicated securities floating around on bank balance sheets, but for now we will lump all these securities into a category called derivatives.
If there were no defaults, these derivatives would be generating returns in the high teens...perhaps higher. It's hard to tell because the derivatives market that these securities are traded in are opaque. They should have never been allowed to exist in the first place, but these markets are now dead, so it is pointless to talk about regulating a dead market. The laws of nature (specifically the second law of thermal dynamics...someone should write an in depth analysis of how this law of physics applies so well to modern markets, but we need to leave that up to someone far smarter than myself. I would be happy to explain this connection in some general detail later on. It's fascinating) have already taken care of that for us.
The reason I bring up Geitner's plan to "encourage private entities to take on these toxic assets" is because the only way to do that is to guarantee some or all of the inevitable losses that the private entity would incur by buying these derivatives at face value. This potential government guarantee is going to come up as a part of the solutions to be outlined later.
What we need to do now is establish some basic truths so we can understand the problems that face us are before we can start to contemplate solutions. It is impossible to get to all the root causes of the current crisis because we would have to define a chain of events, their causes and effects, going all the way back to the moment of creation or further (another fascinating topic for another day).
So upfront we have to acknowledge that we must deal with an incomplete understanding of the forces shaping our world. I will start with the most recent real estate bubble and proceed to define a chain of events that have set the world on a course of financial obliteration (should the situation be left to sort itself out). I am going to focus on the mortgagees and lenders before lightly touching upon the role that securitization and foreign investors had to play in this fiasco.
No Down Payment Mortgages
In early 2006 a median family in orange county California made $61k per year. The median home was $610k. In the 1980's, a few months worth of income would cover a 20% down payment on a median priced house. The 2006 family would have to come up with $122k for a 20% down payment. That is 2 years worth of income. This would be impossible for most families to come up with. The mortgage industry got around this problem a few years prior with the no money down loan. This down payment obstacle was easily circumvented.
Cheap Money
In order to avoid a severe recession in 2001 the fed cut rates substantially and flooded credit markets with massive amounts of cheap money. This money found a home in the real estate market. Money and credit became so abundant that financial firms figured that they were actually losing money by not lending it out. Within the next couple of years they became very creative with their lending programs. They realized if they stuck to the same old fashioned credit guidelines that they would quickly run out of people to lend to and the gravy train would come to a halt. Home prices inflated quickly as more and more people suddenly found themselves able to qualify for a home loan because of this abundant credit. That leads us to the creation of....
Ninja Loans
As more lenders lent more money, home prices skyrocketed. Lenders realized that it didn't matter whether or not borrowers could pay back their loans. Home prices were rising so fast that they would surely get their money back through foreclosure if the borrower defaulted. Demand in the form of speculation rose dramatically. Investors were flipping houses using cheap money just as Wall Street investors did in the late 20's when buying stocks using cheap money on margin. The only problem with this scheme is that home prices had to keep going up forever or this massively leveraged house of cards would come crumbling down. This desperate attempt to keep the system going climaxed with the Ninja loan (No income, No job, No assets). Lenders knew that people making $61k per year could not afford a $610k house no matter how much they played with the debt ratios. But why should it matter? If home prices are going up 20% a year, that $610k house will be worth $732k next year. That's an increase of $122k which is 2X the family's income. They could always cash out that equity in order to pay their bills if they ran into trouble. The problem is that these bills kept getting higher and higher due to the spreading of the housing inflation into the general economy because of borrower's ability to pull out this money at will. This leads into the role of the HELOC.
HELOC's and Inflation in the General Economy
A HELOC is a Home Equity Line of Credit. These are usually set up as 2nd mortgages and allow borrowers to pull money off this line at any time for any reason. Our 2006 median income family would be able to pull money off this equity line to pay credit card bills, buy cars, or make home improvements by simply writing a check. This caused price inflation in the general economy. This is an important point because this rise in economic activity was touted by Wall Street as "The Goldilocks Economy". This encouraged more speculation and caused more inflation. This economic activity and inflation was completely based on debt. This flurry of economic activity emboldened speculators to look for returns in every area of the economy they could find. A commodities bubble started in early 2007 causing oil and food prices to skyrocket.
The Commodities Bubble and the Beginning of the Collapse
This rise in inflation drew concern from the Federal Reserve. The Federal Reserve is responsible for keeping inflation in check. In 2007 we were looking at real inflation rates of around 12% (I know this differs from the government statistics, but those numbers are manipulated. Using the same methodologies that were used in the 80's we get a much higher inflation rate. There are some ridiculous tricks the government uses to manipulate their figure that I can also go into another day...another fascinating topic. For more info on this topic check out http://shadowstats.com ). In response to the inflation danger Alan Greenspan decided to raise interest rates. This means tightening credit. In a normal economy this would be the prudent thing to do, but what we were experiencing at the time was a debt fueled consumptive orgy. This little adjustment to the credit market was enough to pop the bubble. Here is why...remember that the reason why so many borrowers were getting approved was because lenders thought that the borrower could always refinance out of any situation given that the equity in the home was growing 10 - 20% per year. By tightening credit even a little bit meant that there was a chance that the borrower may not be able to refinance out of this situation. Borrowers and lenders alike knew that the only way to avoid catastrophe was to keep this refinancing cycle going forever. But the consequence of this refinancing cycle was ever increasing inflation. If the refi boom continued, price inflation would eventually strangle the economy. Our foreign creditors would eventually have to sell their dollar holdings causing a run on the dollar and a Weimar Republic style hyperinflationary spiral. The Fed faced a hard choice. They could either pop the real estate bubble or wait for this hyperinflation to take hold. We are now suffering the consequences of their decision. Whether or not they made the right one is irrelevant at this point.
Sub Prime Foreclosures
All it took was for credit to tighten slightly for lenders to start declining sub prime borrowers' refinance applications. Now they wanted to verify income because money was a little tighter and it just didn't make sense to take on the risk of these borrowers defaulting as they knew the borrowers would have to default in a tighter credit market. Thus the first foreclosures started the deflationary spiral that we are in now. These foreclosures started lowering the home values in the surrounding area making it harder for anybody to refinance. That's when reality slapped the financial world on the backside of its retarded head and let it know that the day of reckoning was upon us. Here's why...
Securitization
At the beginning of the real estate bubble, a bunch of Phd's working for firms like Morgan Stanly, Bear Stearns, Lehman Brothers, etc. came up with some very complicated models to determine the risk return profile of all types of mortgages. They used these models to package up mortgages and sell them in the derivatives market. The reason I bring this up is because the first assumption behind all of these models is that home prices would go up forever. These rosy predictions made the securities that they created out of these mortgages look extremely attractive. The models weren't questioned thoroughly because they were created by math geniuses from MIT and Harvard. Nobody except the math geniuses could understand the models anyway. So these firms had ratings agencies rate the derivatives based on the rosy predictions of these models so they could be sold worldwide. They went so far as to rate sub prime mortgages "Triple A" through "tranching" ( http://www.youtube.com/watch?v=0YNyn1XGyWg ). These "Triple A" securities found their way into pension funds, slush funds, money markets, central banks, foreign sovereign wealth funds just to name a few. When home prices finally fell, the first assumption behind the models that gave these securities their rosy ratings was proven to be false. That meant that the whole model had to be thrown out. Without a model, how do you know how much these securities are worth? I know from my experiences as a kid of collecting baseball cards that a card is only worth what someone else is willing to pay for it. It didn't matter what the pricing guides said...it is only worth what you can get for it. Financial firms quickly found out that these securities weren't worth but a small fraction of what the model told them it was worth. This has forced banks to continue to write these derivatives off their books causing them to become insolvent.
Deflation Takes Hold
As more people default, banks are forced to write down more of these assets causing credit to tighten up causing more defaults causing more write downs causing more credit to tighten up. This tightening of credit affects the entire economy the same way that real estate inflation leaked into the entire economy. Businesses who leveraged themselves with the cheap and easy money of years past now count on that credit to survive. Without it they have to either downsize or fold up. This causes job losses which cause defaults which cause write downs which causes credit to tighten up. Are you starting to notice a pattern here?
That's a very brief overview of how we got to where we're at today. The question is...
What now?
We have seen trillions of dollars get thrown at this problem with little to no results. We have seen the collapse and consolidation of giant financial institutions once thought to be indestructible. The current administration wants to re-inflate the bubble that got us into this mess in the first place by rewarding the speculative lenders and borrowers with interest free money from the Fed, bailout money from the treasury, and loan guarantees and restructuring through the FHA, Fannie/Freddie, and the FDIC. The idea is that they will keep throwing more and more money at the speculators forcing them to re-inflate without any regard for future consequences. Remember when Greenspan had to decide between real estate deflation and hyper-inflation? Well since that time we have more than doubled the M3 money supply and when that cash reaches the spending stream through another speculative bubble, hyper-inflation will be assured. This path should not be considered to be a reasonable course of action.
Going Back to Geitners Call to Bring in Private Equity
I believe that the government will eventually decide to guarantee all losses on derivative assets in order to attract private money. This would give the very people who nearly brought the world economic destruction risk free returns in the high teens. This rewarding of reckless behavior sets a new precedence for moral hazard that may linger for generations to come. This course of action should not be considered and if it does come to pass it will ensure a future crisis of even greater proportions.
My Proposal
Instead of giving these risk free returns to private investors, why can't we give the risk free returns to people who have managed to save money throughout this whole debacle? People who managed to save money probably haven't leveraged themselves with mortgage and credit card debt and should be rewarded for their sensibilities. Let savers invest in a fund that buys these derivatives from the bank at the overpriced face value with a guarantee that the government would cover any losses. The returns on this fund should be tax free and they would be in the high teens. These would be demand deposits that individuals could invest in just as they do with a savings account or money market fund. This would allow the banks to use these savings accounts as a capital base for future loans. With the toxic assets now off the books, banks would be free to lend.
Individuals who managed to maintain a high credit score would be able to borrow from the very bank that they deposit with at current low rates and invest it back in the account in order to make a risk free spread of at least 10%. The borrower would use the account itself as collateral on other loans.
This plan solves several problems. First, people using leverage to invest in this fund are soaking up some of the massive money creation thereby preventing a hyper-inflationary recovery because the savings will not enter the spending stream right away. In the meantime, banks will have the toxic assets off their books and be well capitalized. This will allow them to start lending to businesses again. This will stem job losses. The individuals investing in this fund will eventually generate returns large enough to allow them to re-enter the housing market once they have saved enough for a down payment. Their excellent credit profiles will allow them to take advantage of the lower housing prices at the same time the economy recovers.
This fund will not require any new bureaucratic agency or any special underwriting to decide who gets to participate because ANY INDIVIDUAL can participate. But we are still rewarding those banks that made bad investments aren't we?
Not all banks made bad decisions and we shouldn't reward the ones that did. Many regional and community banks refused to make "Sub Prime" or "No Money Down" loans because they knew there would be consequences. They shouldn't be punished for their foresight. I propose that we make the fund only available to individuals who deposit with these banks. These are the types of banks that we want supervising this program. The larger banks will be forced out while these smaller responsible banks will grow immensely.
This is not a quick fix solution and will be painful, but it is the only responsible course of action. It rewards the responsible savers and lenders and initiates a recovery that doesn't result in hyper-inflation. It will stabilize home prices without direct government intervention and will free up credit for those businesses who managed to survive because they weren't overleveraged to begin with. Everyone involved will have learned a valuable lesson regarding leverage and speculation. Once the recovery starts we can deal with other serious structural issues (Trade deficit, National Debt, Fractional Reserve Banking), but I'll leave those for another day. First we have to avoid deflationary destruction and then avoid hyper-inflation before we can realistically talk about these other serious issues.
If there were no defaults, these derivatives would be generating returns in the high teens...perhaps higher. It's hard to tell because the derivatives market that these securities are traded in are opaque. They should have never been allowed to exist in the first place, but these markets are now dead, so it is pointless to talk about regulating a dead market. The laws of nature (specifically the second law of thermal dynamics...someone should write an in depth analysis of how this law of physics applies so well to modern markets, but we need to leave that up to someone far smarter than myself. I would be happy to explain this connection in some general detail later on. It's fascinating) have already taken care of that for us.
The reason I bring up Geitner's plan to "encourage private entities to take on these toxic assets" is because the only way to do that is to guarantee some or all of the inevitable losses that the private entity would incur by buying these derivatives at face value. This potential government guarantee is going to come up as a part of the solutions to be outlined later.
What we need to do now is establish some basic truths so we can understand the problems that face us are before we can start to contemplate solutions. It is impossible to get to all the root causes of the current crisis because we would have to define a chain of events, their causes and effects, going all the way back to the moment of creation or further (another fascinating topic for another day).
So upfront we have to acknowledge that we must deal with an incomplete understanding of the forces shaping our world. I will start with the most recent real estate bubble and proceed to define a chain of events that have set the world on a course of financial obliteration (should the situation be left to sort itself out). I am going to focus on the mortgagees and lenders before lightly touching upon the role that securitization and foreign investors had to play in this fiasco.
No Down Payment Mortgages
In early 2006 a median family in orange county California made $61k per year. The median home was $610k. In the 1980's, a few months worth of income would cover a 20% down payment on a median priced house. The 2006 family would have to come up with $122k for a 20% down payment. That is 2 years worth of income. This would be impossible for most families to come up with. The mortgage industry got around this problem a few years prior with the no money down loan. This down payment obstacle was easily circumvented.
Cheap Money
In order to avoid a severe recession in 2001 the fed cut rates substantially and flooded credit markets with massive amounts of cheap money. This money found a home in the real estate market. Money and credit became so abundant that financial firms figured that they were actually losing money by not lending it out. Within the next couple of years they became very creative with their lending programs. They realized if they stuck to the same old fashioned credit guidelines that they would quickly run out of people to lend to and the gravy train would come to a halt. Home prices inflated quickly as more and more people suddenly found themselves able to qualify for a home loan because of this abundant credit. That leads us to the creation of....
Ninja Loans
As more lenders lent more money, home prices skyrocketed. Lenders realized that it didn't matter whether or not borrowers could pay back their loans. Home prices were rising so fast that they would surely get their money back through foreclosure if the borrower defaulted. Demand in the form of speculation rose dramatically. Investors were flipping houses using cheap money just as Wall Street investors did in the late 20's when buying stocks using cheap money on margin. The only problem with this scheme is that home prices had to keep going up forever or this massively leveraged house of cards would come crumbling down. This desperate attempt to keep the system going climaxed with the Ninja loan (No income, No job, No assets). Lenders knew that people making $61k per year could not afford a $610k house no matter how much they played with the debt ratios. But why should it matter? If home prices are going up 20% a year, that $610k house will be worth $732k next year. That's an increase of $122k which is 2X the family's income. They could always cash out that equity in order to pay their bills if they ran into trouble. The problem is that these bills kept getting higher and higher due to the spreading of the housing inflation into the general economy because of borrower's ability to pull out this money at will. This leads into the role of the HELOC.
HELOC's and Inflation in the General Economy
A HELOC is a Home Equity Line of Credit. These are usually set up as 2nd mortgages and allow borrowers to pull money off this line at any time for any reason. Our 2006 median income family would be able to pull money off this equity line to pay credit card bills, buy cars, or make home improvements by simply writing a check. This caused price inflation in the general economy. This is an important point because this rise in economic activity was touted by Wall Street as "The Goldilocks Economy". This encouraged more speculation and caused more inflation. This economic activity and inflation was completely based on debt. This flurry of economic activity emboldened speculators to look for returns in every area of the economy they could find. A commodities bubble started in early 2007 causing oil and food prices to skyrocket.
The Commodities Bubble and the Beginning of the Collapse
This rise in inflation drew concern from the Federal Reserve. The Federal Reserve is responsible for keeping inflation in check. In 2007 we were looking at real inflation rates of around 12% (I know this differs from the government statistics, but those numbers are manipulated. Using the same methodologies that were used in the 80's we get a much higher inflation rate. There are some ridiculous tricks the government uses to manipulate their figure that I can also go into another day...another fascinating topic. For more info on this topic check out http://shadowstats.com ). In response to the inflation danger Alan Greenspan decided to raise interest rates. This means tightening credit. In a normal economy this would be the prudent thing to do, but what we were experiencing at the time was a debt fueled consumptive orgy. This little adjustment to the credit market was enough to pop the bubble. Here is why...remember that the reason why so many borrowers were getting approved was because lenders thought that the borrower could always refinance out of any situation given that the equity in the home was growing 10 - 20% per year. By tightening credit even a little bit meant that there was a chance that the borrower may not be able to refinance out of this situation. Borrowers and lenders alike knew that the only way to avoid catastrophe was to keep this refinancing cycle going forever. But the consequence of this refinancing cycle was ever increasing inflation. If the refi boom continued, price inflation would eventually strangle the economy. Our foreign creditors would eventually have to sell their dollar holdings causing a run on the dollar and a Weimar Republic style hyperinflationary spiral. The Fed faced a hard choice. They could either pop the real estate bubble or wait for this hyperinflation to take hold. We are now suffering the consequences of their decision. Whether or not they made the right one is irrelevant at this point.
Sub Prime Foreclosures
All it took was for credit to tighten slightly for lenders to start declining sub prime borrowers' refinance applications. Now they wanted to verify income because money was a little tighter and it just didn't make sense to take on the risk of these borrowers defaulting as they knew the borrowers would have to default in a tighter credit market. Thus the first foreclosures started the deflationary spiral that we are in now. These foreclosures started lowering the home values in the surrounding area making it harder for anybody to refinance. That's when reality slapped the financial world on the backside of its retarded head and let it know that the day of reckoning was upon us. Here's why...
Securitization
At the beginning of the real estate bubble, a bunch of Phd's working for firms like Morgan Stanly, Bear Stearns, Lehman Brothers, etc. came up with some very complicated models to determine the risk return profile of all types of mortgages. They used these models to package up mortgages and sell them in the derivatives market. The reason I bring this up is because the first assumption behind all of these models is that home prices would go up forever. These rosy predictions made the securities that they created out of these mortgages look extremely attractive. The models weren't questioned thoroughly because they were created by math geniuses from MIT and Harvard. Nobody except the math geniuses could understand the models anyway. So these firms had ratings agencies rate the derivatives based on the rosy predictions of these models so they could be sold worldwide. They went so far as to rate sub prime mortgages "Triple A" through "tranching" ( http://www.youtube.com/watch?v=0YNyn1XGyWg ). These "Triple A" securities found their way into pension funds, slush funds, money markets, central banks, foreign sovereign wealth funds just to name a few. When home prices finally fell, the first assumption behind the models that gave these securities their rosy ratings was proven to be false. That meant that the whole model had to be thrown out. Without a model, how do you know how much these securities are worth? I know from my experiences as a kid of collecting baseball cards that a card is only worth what someone else is willing to pay for it. It didn't matter what the pricing guides said...it is only worth what you can get for it. Financial firms quickly found out that these securities weren't worth but a small fraction of what the model told them it was worth. This has forced banks to continue to write these derivatives off their books causing them to become insolvent.
Deflation Takes Hold
As more people default, banks are forced to write down more of these assets causing credit to tighten up causing more defaults causing more write downs causing more credit to tighten up. This tightening of credit affects the entire economy the same way that real estate inflation leaked into the entire economy. Businesses who leveraged themselves with the cheap and easy money of years past now count on that credit to survive. Without it they have to either downsize or fold up. This causes job losses which cause defaults which cause write downs which causes credit to tighten up. Are you starting to notice a pattern here?
That's a very brief overview of how we got to where we're at today. The question is...
What now?
We have seen trillions of dollars get thrown at this problem with little to no results. We have seen the collapse and consolidation of giant financial institutions once thought to be indestructible. The current administration wants to re-inflate the bubble that got us into this mess in the first place by rewarding the speculative lenders and borrowers with interest free money from the Fed, bailout money from the treasury, and loan guarantees and restructuring through the FHA, Fannie/Freddie, and the FDIC. The idea is that they will keep throwing more and more money at the speculators forcing them to re-inflate without any regard for future consequences. Remember when Greenspan had to decide between real estate deflation and hyper-inflation? Well since that time we have more than doubled the M3 money supply and when that cash reaches the spending stream through another speculative bubble, hyper-inflation will be assured. This path should not be considered to be a reasonable course of action.
Going Back to Geitners Call to Bring in Private Equity
I believe that the government will eventually decide to guarantee all losses on derivative assets in order to attract private money. This would give the very people who nearly brought the world economic destruction risk free returns in the high teens. This rewarding of reckless behavior sets a new precedence for moral hazard that may linger for generations to come. This course of action should not be considered and if it does come to pass it will ensure a future crisis of even greater proportions.
My Proposal
Instead of giving these risk free returns to private investors, why can't we give the risk free returns to people who have managed to save money throughout this whole debacle? People who managed to save money probably haven't leveraged themselves with mortgage and credit card debt and should be rewarded for their sensibilities. Let savers invest in a fund that buys these derivatives from the bank at the overpriced face value with a guarantee that the government would cover any losses. The returns on this fund should be tax free and they would be in the high teens. These would be demand deposits that individuals could invest in just as they do with a savings account or money market fund. This would allow the banks to use these savings accounts as a capital base for future loans. With the toxic assets now off the books, banks would be free to lend.
Individuals who managed to maintain a high credit score would be able to borrow from the very bank that they deposit with at current low rates and invest it back in the account in order to make a risk free spread of at least 10%. The borrower would use the account itself as collateral on other loans.
This plan solves several problems. First, people using leverage to invest in this fund are soaking up some of the massive money creation thereby preventing a hyper-inflationary recovery because the savings will not enter the spending stream right away. In the meantime, banks will have the toxic assets off their books and be well capitalized. This will allow them to start lending to businesses again. This will stem job losses. The individuals investing in this fund will eventually generate returns large enough to allow them to re-enter the housing market once they have saved enough for a down payment. Their excellent credit profiles will allow them to take advantage of the lower housing prices at the same time the economy recovers.
This fund will not require any new bureaucratic agency or any special underwriting to decide who gets to participate because ANY INDIVIDUAL can participate. But we are still rewarding those banks that made bad investments aren't we?
Not all banks made bad decisions and we shouldn't reward the ones that did. Many regional and community banks refused to make "Sub Prime" or "No Money Down" loans because they knew there would be consequences. They shouldn't be punished for their foresight. I propose that we make the fund only available to individuals who deposit with these banks. These are the types of banks that we want supervising this program. The larger banks will be forced out while these smaller responsible banks will grow immensely.
This is not a quick fix solution and will be painful, but it is the only responsible course of action. It rewards the responsible savers and lenders and initiates a recovery that doesn't result in hyper-inflation. It will stabilize home prices without direct government intervention and will free up credit for those businesses who managed to survive because they weren't overleveraged to begin with. Everyone involved will have learned a valuable lesson regarding leverage and speculation. Once the recovery starts we can deal with other serious structural issues (Trade deficit, National Debt, Fractional Reserve Banking), but I'll leave those for another day. First we have to avoid deflationary destruction and then avoid hyper-inflation before we can realistically talk about these other serious issues.
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